Learn How Forex Brokers make money losses. There are a lot of theories about how forex brokers make money and how they make losses. This is something Forex brokers may never reveal to you and this is the reason why forex traders up to 95% make losses and only 5% succeed. But once you understand how a forex broker operates after reading this, you will know which side you belong to, to either the 95% which is side A or the 5% which side B.
How do Forex Brokers make money and do they make losses? First theory:
In 1999, less than a decade ago, there was simply no retail or individual forex trading. Foreign exchange dealing was pretty much confined to major banks, hedge funds, and high net worth individuals mainly because of the trading capital requirements. Generally, the minimum trade size was $1,000,000 USD.
However, as information started to spread about the profit potential that forex trading has, even though they were unable to trade on the conventional interbank market because they did not have large quantities of money to deal with, more people decided to.
For those investors who had about $10,000 to $50,000 to invest or less, there was an increasing need for forex market access, and so the retail forex market was born. To meet this high demand, new forex brokers began (and still are) springing up rapidly, but this part of forex trading is still highly unregulated.
Many of the forex brokers out there work under the model of ‘market maker’ or bucket shop, and these are the guys who really have NO interest in seeing you succeed as a trader. About why? Are you asking?
Well, it is their job to make access to the forex market accessible (hence the term market maker) to smaller investors. They need to be able to complete every order you put on your trading platform in order to do so, and they do this by taking the opposing position in every trade you make.
Well, since with every trade you make, they will have an opposing place available, they will actually lose money every time you have a winning trade. Imagine that the EUR / USD pair was purchased because you think the Euro would appreciate it. Well, the broker would have to take a position where they are selling EUR / USD in order for your transaction to go through in order to provide market access to you.
It is in their best interest for the Euro to depreciate in value, or to see you losing in a trade because they are in a selling position here. And bear in mind that this will never, ever be disclosed to you by your forex market maker, as only a small minority of traders really truly understand their business model, and so the majority of traders will fall prey to it.
An Electronic Communications Network (ECN) is the other form of forex broker business model, and it is more trader-friendly simply because the broker does not have a vested interest in seeing you struggle. In order to understand how this form of setup works, note that having market access and liquidity is the aim of any broker.
By taking an opposing stance to each trade you place, a forex market maker does this, but an ECN broker buys this by routing your trade order through its communications network and matching it with another trade (for example, if you put a purchase order on a certain currency pair, the ECN will match you with another trader selling the same pair).
ECN brokers are really your best choice, as using a broker that provides this sort of trading setup is much easier to make money. Since they have no vested interest in making you losing money and only care about having a network where they can match your orders with other traders, as you would have with a market maker, you will never have any issues removing your income.
Online access to your account so that you can exchange anywhere in the world, very high leverage that allows you to make a large amount of money from a very small account, transactions are commission-free and even forex spreads are incredibly tight. Forex trading is fantastic.
Given that you, the forex trader, have a range of perks, have you ever wondered how money is made by your retail forex broker? And why are there so many brokers with retail forex out there? Forex broker ads are, after all, everywhere and the rivalry tends to be quite stiff. So how does your forex broker, exactly, make money?
The response might surprise you. Your forex broker believes that when you sell, you will lose money over the long run. It is a very secure assumption, considering that 95 per cent of forex traders lose capital. Each broker has to determine whether the group (95 per cent) of traders who lose money or the group (5 per cent) who make money will be part of a new account.
If I gave you a coin and said that 95 per cent of the time it will land on heads, I think you’d probably want to hold the coin so you can use it to win some bets with your buddies and 2) still believe that the coin would land on heads.
This is what your forex broker does precisely. It is presumed that any new account belongs to “group B”-those traders who will lose money. Your broker is only too happy to believe that you belong to this party because 95 per cent of the traders belong to this group.
Your broker will re-assign you to “group A” after some time, if you have consistently made profits, these are the fortunate 5% of traders who consistently make money. Your broker will lump your trades with all of the rest of group A and hedge against your trades after you have joined this group. So, for instance, if all Group A traders have purchased EUR / USD, your broker can position a trade on the interbank forex market to cover any Group A gains earned on this trade.
Basically, the broker puts up with traders from group A but is more interested in acquiring accounts from group B. This is because if a Group B trader loses $7,000, that is, he blows up his $7,000 account entirely, then the broker gets all that money. The broker doesn’t make money on the spread; on the losing accounts, the broker loses money.
This is also why new clients are actively marketed by brokers. In order to keep making money, brokers need “new blood,” many of the traders in group B will give up trading or move to another broker.
Like any other organization in the history of the industry, the raison d’etre of your broker is to make as great a profit as possible. There are just as many forms as there are brokers to do this. However, for those who are in it for the long haul, it is normally better to follow a set of practices that are considered fair by their customers: certain limits are set, and operating above them will cost their credibility to a brokerage, and its customers along with it.
Therefore, straying beyond these parameters is not viewed as being in line with the company’s long-term objectives. How strictly these limitations are implemented, particularly when there is little risk of customers actually being aware of any transgression, varies again from company to company. For the sake of convenience, we presume in this article that everyone in the company is squeaky clean as if at any moment every customer might peer into the back office of the broker and dissect every trade. This is simply not the case, and this opaqueness is taken advantage of by many brokers, but the specifics are better left for another debate.
So let’s get into the specifics of how forex brokers operate, without further ado. Retail forex brokers are somewhat separated from the top-tier interbank market to offer a service that would otherwise not be available, which is to give an investor with a $10,000 bankroll the ability to bet on the very exclusive forex market until recently. Two types of brokers that have access at the retail level are commonly known to be: Electronic Communications Networks (ECNs) and Market Makers. In general, ECNs are much more exclusive, requiring larger deposits to get started, but are seen as providing the interbank market with more direct entry. There are definitely benefits to this, as we can see, but some drawbacks as well. On the other hand, market makers are more often than not the counterparty to the transactions of their customers, creating something of a conflict of interest, while ECNs benefit from commission fees paid directly to customers, regardless of the results of any transaction, they are seen as completely impartial-an ECN has no reason for a customer to lose money.
In fact, if a customer is good, one might claim that an ECN stands to benefit more, meaning that he/she will be around longer and they will be able to receive more commission fees from them. On the other hand, a market maker, being the counterparty to the trade of a client, makes money if the consumer loses money, creating an opportunity for some shady practices, particularly in an unregulated market. Among individual brokers, the degree to which this occurs varies. There are also some advantages of trading with a market maker (see our article on ECNs vs. Market Makers) Some brokers also have a service that does not exactly fit into either category. Depending on complicated algorithms or on a dealing desk, they route different orders differently, evaluating each order and trying to fill it in the way that would be most advantageous to the bottom line of the broker. They can balance such customer orders against each other, build an in-house market efficiently, they can choose to be the counterparty to the trade of a customer (trade “against” the customer), or they can offset their position through a higher-tier counterparty with a hedge. Notice that the market maker is primarily concerned with the management of its net exposure, and NOT with the company of any particular person. Specifically, they are NOT firing for your stop losses but could be firing for stop clusters.
You will note that market mechanics are responsible for the variance in bid / ask spreads, as well as for slippage if you have already read the first article in the sequence, Forex Market Structure. So it seems like the pet peeves of the two greatest inexperienced traders are not so much a feature of who their broker is, but rather their lack of knowledge of how the forex market works. During times of low liquidity, a broker that provides a fixed spread prefers not to fill orders because this will expose them to excessive risk, and as long as their task is to appeal to their customers, note that they are mainly in business to make money for themselves. Some brokers also sell order fills that are guaranteed, such as “guaranteed stop losses.”
Again, if there is no counterparty to take the trade, in order to fulfil this guarantee, they have to expose themselves to risk, so don’t be surprised if you see such a broker citing different/delayed prices along substantial trend lines or levels of support/resistance. Be particularly mindful of brokers who supply both guaranteed fills AND fixed spreads. When a broker proposes something that appears too good to be true, you would be wise to ask how specifically a risky practice can be assisted by their business model. As a general rule, only when your interests are matched with theirs can broker support you. Brokers, on the other hand, offer a very useful service without which you would not have the ability to benefit from the forex market, so please think about how it all works together before blaming anything on your broker.
You’ve heard of the 3rd form of broker … A broker at STP?
Many traders do not feel comfortable dealing with “market makers,” as market marker brokers have the option of hanging on to the other side of their customer’s transactions, which would mean that if they genuinely want to do so, they would benefit from the gains of their customer and lose money when their customers won. Of course, most market manufacturers do not really do this; market manufacturers typically only try to balance their customer’s trades with other customers’ trades in order to benefit from the spread and then hedge whatever they do not match on the market. Nevertheless, as a forex broker knowingly betting against their customers would be a major conflict of interest if it were to happen, many traders are not comfortable with market makers.
Instead, trading with a real STP broker will be one option for those not happy with trading with market makers. An STP broker is a broker that is not a market maker, STP brokers are not liquidity providers and therefore all trades with an STP broker are transferred directly to their liquidity provider(s) immediately. An STP broker will benefit as a middleman from the difference between the spread they charge their customers and the spread they are able to get from their liquidity provider(s). Straight Through Processing Brokers are called STP brokers because all the trades placed with them effectively pass directly through them and into someone else’s hands.
For beginner and intermediate traders, trading with a real STP broker is usually a good idea. The spreads charged by STP brokers are typically very competitive and not usually any higher than those charged by market makers to their retail customers, as STP brokers can route their orders at any given time to the liquidity provider with the cheapest spread / best price. And for novice traders, finding a broker that they can be sure is 100 per cent ‘on their side’ is an immense plus in the interests of an STP broker that their customers prosper and make money so that they continue to trade.
You should not confuse STP brokers with ECN brokers. A broker must have real-time Depth of Market (DOM) information in a window on their trading platform to be a true ECN broker, displaying every single order to allow traders to see exactly where the liquidity is located. ECN brokers do not just send orders directly to a liquidity provider such as STPs, ECN brokers charge a fee to have a marketplace where traders can exchange on a fair basis with each other, and they do not really care about which of their traders wins and which of their traders loses because it does not affect them. In the other hand, an STP broker genuinely tries to do better with all of its traders, since that is what is in the best interest of an STP broker.
I suggest eToro for those beginner and intermediate traders searching for an STP broker. Since eToro is a real broker of STPs. On their live accounts, eToro provides traders with an unrestricted practice/demo account and assured stop losses so that there is no DEBT risk. Making them a perfect broker to improve their trading abilities for novices and intermediate traders.
Now that you have understood how forex brokers make and lose money, where do you belong?
- Side B, the 5%: those who make profits
- Side A: 95%: those who lose
Let me know in the comments below, and feel free to share this article.